Dividend Investing: 3 Common Mistakes That Ruin Returns

Dividend investing is based on the idea that by paying a dividend, a company has established itself as relatively stable financially, and that therefore it is worthy for investment consideration. However, dividend investing can be tricky, and it is easy to make mistakes. Making mistakes in dividend stocks can be very costly, as such mistakes often come from the standpoint of complacency. Here are three common mistakes to avoid.

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1. Chasing yield

This is probably the biggest mistake that dividend investors make. Investors will often judge a company’s value or upside potential by its dividend yield, and they will reason that a stock with a high yield must be cheap. But there are two problems with stocks that have high dividend yields. The first is that they often have very slow dividend growth rates.

So while the dividend may be high today, it could remain the same or rise only slightly in the long term, and this will restrict your gains. On the other hand, a company that is growing its dividend but which pays a low dividend will likely outperform in the long run because it is using the capital it is not paying out in the form of a dividend to grow its business. Thus, if you buy a dividend growth stock now, in 10 years, the dividend could be very large relative to your initial investment, and this is what you want when you are investing in dividend companies.

The second issue is that a high dividend could be in trouble, meaning that the company could be forced to cut it. In this low-yield environment, investors should view high yields with skepticism, and they need to make sure that they understand why the market isn’t willing to bid up a high-yielding stock. While you may spot an overlooked gem, this is unlikely, considering that we are in a stock bull market and that investors are generally viewing the glass as half full. Thus, a high yield can often be a red flag, and it might be best to stay away.

2. Assuming that dividend yields will protect you from losses

Many investors assume that dividend-paying stocks have some sort of “floor” set by the dividend. They reason that the dividend will draw in dividend investors when it reaches a certain point, and that therefore the stock will not fall below this point. However, one thing that investors need to realize is that dividend yields are historically low for stocks.

The S&P 500 yields about 1.8 percent, whereas historically, the yield has been 2.5 to 3 times larger on average. One of the reasons that yields are so low is that bond prices are so low, and investors buy stocks based on the relative yield available on stocks versus bonds. But what if bond prices fall? Bonds have historically yielded substantially more than they do currently, and if bond prices fall, then all of a sudden these dividend yields will begin to look paltry, and investors will begin to sell.

So is there a floor? Maybe, but realize that this floor may not be as high as you would assume given today’s bond prices. The floor set by the dividend payment could be 50 percent to 75 percent below the current share price, and in that case, for all intents and purposes, the floor is essentially nonexistent.

3. Reinvesting dividends

A popular strategy that dividend investors employ is to have their brokers automatically reinvest their dividends into the stocks of the companies that paid them. So when McDonald’s pays a dividend, the investor automatically takes that money and buys more McDonald’s stock. The reasoning behind it is that your dividend payment compounds. In fact, if you reinvest dividends into a company that regularly raises its dividend, you get “double compounding” — your dividend grows on a per-share basis and your net dividend grows because you own more shares. Sounds great, right?

The trouble is that dividend reinvestment is akin to blindly buying stock regardless of the price, and this is a huge investing mistake that can limit your returns.

The solution to this problem is fairly simple: reinvest your dividends, but not necessarily into the companies that paid them. There are various ways to do this, but a simple way is to collect dividends from all of your dividend-paying stocks for a quarter and then using that capital to buy stock in the one that this underperforming the market. This way you still get the “double compounding” effect, but you avoid the mistake of purchasing overvalued stock.